If an independent Scotland wants to keep the pound, it may lose its banks

With an independent Scotland losing control of monetary policy, its banks will
flee to England for safety - unless it opts to stay out of the EU

The issue of what currency an independent Scotland would use has not been settledPhoto: Alamy

By Philip Booth

1:00PM GMT 21 Mar 2014

The arguments rage on about the currency that the Scottish government should use after independence. At one time, the Scottish nationalists wanted to adopt the euro but the eurozone crisis put paid to that. However, despite Scottish rejection of the euro, in many ways the EU remains the elephant in the room in this debate.

George Osborne has told Scotland that a future independent Scotland will not be allowed to enter a currency union with the rest of the UK. Of course, it may not be George Osborne’s decision – Ed Balls might be Chancellor of the Exchequer. Or, indeed, George Osborne may change his mind. Nevertheless, it is an understandable position for the Coalition government to take. A currency union could cause a huge headache for what remained of the UK.

The euro crisis proved two things. First, countries in a currency union can too easily become responsible for each other’s debt. Technically, this is avoidable. However, it is difficult to stop a central bank in a currency union from accepting bonds of all the member countries in the union as part of its normal monetary operations. The central bank – and hence all the countries in the union – can easily become exposed to the credit risk of the member governments.

Secondly, if the central bank in a monetary union is going to act as lender of last resort to all the commercial banks in all the countries of a monetary union, that central bank will end up taking a hit if one of those commercial banks goes bust. This leads to pressure to unify banking regulation and supervision across monetary unions.

These are precisely the problems that we have in the eurozone. Many of those who supported the euro believed that fiscal policy, monetary policy and banking regulation could be divorced but, in practice, this has become very difficult to achieve. Separating these things is, in my view, desirable. However, if we are to achieve it, we must ensure that troubled banks do not get help from the central bank. Similarly, we must somehow ensure that the central bank does not end up with dodgy government debt on its balance sheet.

The practical reality, given the current way we regulate banks, is that monetary union would be seen as requiring a fiscal agreement and a banking union. Then some might ask – “what is the point of Scottish independence?”

So, if a monetary union is ruled out either because the rest of the UK does not want one or because it would in effect undermine the efforts of Scotland to be a separate country, how about the “sterlingisation” of Scotland? This has been mooted by many supporters of free markets and unregulated banking systems and it has a lot going for it.

Under this model, Scotland just adopts the pound in the same way as Montenegro has adopted the euro. It does not need permission from George Osborne to do so, any more than I need permission from Barack Obama to buy the Daily Telegraph using dollars. Alternatively, the Scottish government could issue Scottish pounds but all backed by rest-of-UK government securities – a model Ireland used for several decades after independence.

Under this model, the Scottish central bank could not print money at will. Given the size of Scotland, and the fact that it would be a relatively new country, it would also not be able to borrow very much to build up reserves. The Scottish commercial banks could expect no support from the central bank and they would have to behave cautiously. It would also be very difficult to have a comprehensive deposit insurance system. Andrew Lilico has previously argued for this model which really would be ushering in a free market in currency and banking through the back door.

Indeed, this is arguably the only practical option for Scotland. But, there is a hitch. EU rules provide for freedom of establishment for any bank across all EU member countries, without a separate legal personality in each country in which it is operating. In principle this policy is designed to promote free trade but, as the Icelandic banking crisis showed, it is a policy with undesirable side effects.

In the case of Scotland, it may well also have interesting implications. The whole Scottish banking industry – and quite possibly much of the rest of the financial services industry – would be likely to move from Scotland to London if Scotland adopted the pound without a currency union. Any bank that moves to London would get the advantage of support from the Bank of England and could then operate through branches in Scotland. Why would a commercial bank not take the subsidy? And how would the pro-independence movement like that?

There is no obvious way out of this conundrum. Though one possibility, of course, would be for an independent Scotland not to decide not to join the European Union.

Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs